Friday, December 30, 2016

Making forecasts is of course foolish, but to a degree it's necessary. It's important to have a view on both the economy and on what the market expects of the economy in order to invest with confidence—confidence being a key ingredient for successful long-term investing. For example, taking on risk when the market is risk averse is potentially more rewarding than taking on risk when the market demands a high price for it. In a nutshell, markets move when the future turns out to be different than what was expected, so it pays to have a view on what is expected and what is likely.

So that readers may judge how successful (or unsuccessful) I've been in this regard, it has been my custom for a number of years to annually review the success or failure of prior predictions while at the same time offering up predictions for the future.

I was generally optimistic, because I thought the market was still overly concerned about the economy's ability to grow, and because I thought the economy had lots of upside potential that could be unlocked with more growth-oriented policies. I thought the Fed would move very slowly to raise short-term interest rates. I wasn't at all convinced that Trump's policies would be good for the economy, since at the time he was emphasizing a populist, trade-bashing approach, but I didn't rule out an improvement. As it turned out, optimism beat pessimism this past year and I've been rewarded. The economy turned out to be a little better than the market expected.

I advocated holding risk assets, with an emphasis on yield. As it turned out, stocks with higher-than-average dividend yields handsomely outperformed the S&P 500, while almost anything beat the return on cash. I thought real estate would outperform but it didn't, mainly because of the market's concern that higher yields would be bad for the sector. I thought the outlook for gold and commodities was grim because the outlook for the dollar was positive; however, to just about everyone's surprise (including mine), gold and in particular industrial commodities did well this past year despite the dollar's strong performance. I thought emerging markets were due for a strong recovery, and that paid off in spades (e.g., Brazilian equities rose almost 70% in dollar terms this year).

I worried once again (as I have for many years) that the Fed might prove slow to react to the return of confidence, and that as a result they could end up falling behind the inflation curve. So far, however, that doesn't appear to be the case, since inflation expectations remain relatively docile.

Here's what I see in my crystal ball for 2017:

In contrast to the situation a year ago, when I thought the market was insufficiently optimistic, the market today appears more optimistic about the future (e.g., the S&P 500 PE ratio was 18.8 a year ago, and today it's 21). This sets the bar for investing success higher than it was a year ago. The market is priced to good, growth-oriented policies coming out of the Trump administration, so any fumbles along the way are likely to be met with selloffs. (If there's anything we know about Trump, it's that he can confound expectations.) But by and large I expect he will pursue a pro-growth policy agenda, and this will contribute to a measurable and possibly a substantial improvement in the economy's growth. The going is likely to be bumpy at the outset, but over the long haul I expect to see an improving economy and further gains in equity prices and most other risk assets.

I don't necessarily disagree with the market's view that the Fed will raise short-term rates by 50 bps next year. But I worry, as I have for years, that there's a decent chance the market—and the Fed—could be underestimating the degree to which rates should rise as the economy strengthens. The market expects inflation to be well-behaved at somewhere close to 2% for the foreseeable future; I worry it could surprise to the upside. The main driver of higher-than-expected inflation would be a decline in the demand for money. As I pointed out before, if the market's demand for money should decline because of rising confidence and less risk-aversion, there is a virtual mountain of cash sitting on the sidelines that could fuel higher prices, especially if the Fed is slow to take steps to increase the demand for money by raising short-term interest rates. Over the long haul, I think there's a decent chance that interest rates will move up by more than the market currently expects, so risk-free Treasuries don't look very attractive at current levels. The yield spread on riskier bonds has come down a lot over the past year, so while they are still attractive relative to Treasuries, they certainly aren't a steal and should be approached with a degree of caution.

I think the market worries too much about the negative impact that higher interest rates could have on real estate and the economy. That's because the market sees higher rates as a "tightening" of monetary policy (which to be sure is eventually bad, since it's been the proximate cause of almost every recession), when in fact higher rates—for at least the next year—will simply be the natural result of a stronger economy. The time to worry about tight money is when real interest rates are 3% or more and the yield curve is flat or inverted, and we're a long way away from those conditions. Higher rates are not going to kill the real estate market, even though the market almost always reacts as if that's so. Real estate in general should benefit from stronger growth, and it should be a good hedge against rising inflation.

The dollar is fairly strong at current levels, because of several well-known factors: the Fed is the only major central bank that is in rate-hiking mode, and the U.S. economy has a lot more upside potential than almost every other major economy. But the dollar is not yet "too strong," nor is it likely to be a problem for the economy. The dollar is relatively strong because the U.S. economy looks more attractive than most others; if you want exposure to this relatively attractive economy, you're going to have to pay up to get involved. That's reasonable. This is not a situation in which the dollar is strong because there's a shortage of dollars in the world, and that is probably a good explanation for why commodities can continue to rise even as the dollar rises: it's about optimism and growth, not tight money.

A year ago I noted the impressive victory of Argentina's Macri, who, like Trump today, was set to move policies in a more pro-growth direction. Since then we've seen pro-growth surprises in Brazil and the UK (Brexit), and there's likely more to come (e.g., Italy and France). The political winds are in fact shifting in a more pro-growth direction in many countries (a new and better government in Venezuela is almost a certainty), and that is a nice tailwind for most risk assets. Emerging markets still look good, despite the strong dollar, because, again, it's about the return of optimism and growth.

I don't have strong feelings about gold, but I do believe it is still expensive relative to its long-term average real price which I figure is somewhere around $500-600/oz., so I'm not keen on adding it to my portfolio. Oil seems reasonably priced at current levels, and it's unlikely to become too cheap or too expensive for the foreseeable future, thanks to plenty of fracking capacity that is currently on the sidelines and upside economic growth potential.

The important thing about Trump is that he is a businessman with experience in how things work in the real world; he's not an ideologue. He understands and appreciates the power of incentives, and he is distrustful of the power of government to accomplish good things. It's very encouraging that he understands the growth-damaging effects of regulations. He won't always do things "correctly," but he's likely to get good results.

My main concern with Trump is that he fails to understand the benefits of free trade, and his trade advisor, Peter Navarro, is exceptionally clueless in that regard. Whether the two of them can persuade a more trade-savvy Congress to impose punitive tariffs on imports is not clear, however. I'm hoping that their bark ends up being worse than their bite, and practical considerations trump rhetoric in the end. We don't need balanced trade (e.g., no trade deficits), but what we do need is freer trade. For that matter, the economy desperately needs less regulation, not more.

I'm not worried that a much-needed reduction in tax rates will balloon the deficit, because lower tax and regulatory burdens, plus fewer deductions and subsidies, should add significantly to the tax base. I seriously doubt that we'll see a major and foolish rush to spend money on infrastructure; what we need instead is for government to create incentives for more infrastructure spending at the private and local levels, where the risk/reward tradeoffs are best understood.

Thursday, December 29, 2016

According to the folks at the CoStar Group, the commercial real estate market is registering annual price gains of more than 8%, as the rally in prices that began some six years ago continues to impress.

The chart above includes the latest (as of November) Co-Star data. Note that both measures of commercial real estate prices are at new nominal highs and have been increasing at annual rates of 8-10% for a number of years.

Moodys publishes a similar index (second chart above). As both charts show, prices have reached new all-time highs.

As the chart above shows, commercial real estate has been outperforming the residential market in the current cycle, whereas it lagged during the great housing market boom of the early 2000s. But both are performing quite well.

If anything, the action in the commercial real estate market would appear to be at odds with the very low rates of inflation and sub-par rates of growth that we have seen in the current business cycle expansion. My take is that this is evidence, at least in the past year or so, of rising optimism as well as declining demand for money, and both are precursors, in this age of Quantitative Easing, of rising inflation, as I've explained many times before. However, the bond market is still showing modest inflation expectations (e.g., 1.9-2.0%) for the foreseeable future, so it may be premature to sound a rising inflation call. Especially given the impressive strength of the dollar.

As a reminder, real estate is likely to benefit from a strong economy as well as rising inflation.

Friday, December 23, 2016

For years I've been saying that the Fed can't control bond yields, but the myth that the Fed can manipulate yields (e.g., by buying lots of 10-yr Treasuries and/or by buying lots of MBS) persists. Experience tells us that the Fed can only control short-term rates, and even then it is questionable whether the Fed can move rates up or down by more than the market is ready for at any given time. Recall the bond market tantrum earlier this year when the Fed hinted that it might raise rates several times during the course of the year, and the Fed then quickly backed off, raising rates only once (recently). Bond yields are effectively set by market forces, and are heavily influenced by the market's perception of the future of Fed policy, the expected level of inflation, and the outlook for economic growth.

Here are some charts which compare the history of the Fed's purchases of Treasuries and MBS and their corresponding yields. You can judge for yourself whether the Fed has managed to manipulate those yields with its Quantitative Easing programs.

The chart above shows what happened to 10-yr Treasury yields during the Fed's three Quantitative Easing programs. In each period, despite massive bond purchases, the yield on 10-yr Treasuries rose. Ironically, the Fed justified QE by saying it would depress yields, and that in turn would stimulate the economy. What I think really happened to cause yields to rise despite Fed bond purchases was that the Fed's QE efforts supplied badly-needed bank reserves to the system, and that satisfied the market's thirst for safe assets; that in turn resulted in healthier market liquidity, which in turn caused the market to become somewhat more optimistic about future growth, which in turn caused the market to anticipate higher short-term interest rate guidance from the Fed in the future.

The chart above compares the magnitude of the Fed's Treasury purchases with the level of 10-yr yields. It stands to reason that the Fed could potentially manipulate the bond market only if it buys or sells a quantity of bonds that is significant relative to the outstanding supply of those bonds. Thus the rationale for the blue line, which is the ratio of the Fed's holdings of Treasuries relative to the total marketable supply of Treasuries. Several things jump out: 1) during 2008, as Fed holdings of Treasuries were plunging, yields were falling, and 2) in 2013, as Fed holdings of Treasuries was surging as part of QE3, Treasury yields surged (both in contrast to what the Fed promised QE would do), and 3) the Fed currently holds about 18% of outstanding Treasury debt, and that is about the same amount it held at the end of 2004 and less than the 20% of Treasury debt it held at the end of 2002, yet yields today are much lower than they were back then. Tough to see any convincing or enduring correlation between these lines.

The chart above compares the magnitude of the Fed's MBS purchases with the level of MBS yields. Here we see that despite huge MBS purchases in 2009, MBS yields were relatively unchanged. More recently, with Fed holdings of MBS holding relatively steady, yields have surged. No convincing causality or correlation that I can see between these two lines.

The recent surge in bond yields has almost nothing to do with Fed policy, and very little to do with increased inflation expectations. It's mostly about an improving outlook for growth assuming that Trump is able to reduce the tax and regulatory burdens that have been holding back growth for the past decade.

Wednesday, December 21, 2016

It's likely that close to half the population of the U.S. is still fearful of what Donald Trump will do once he becomes the most powerful man on earth. But to judge from the reaction of the stock and bond markets, the other half is ecstatic. Since November 4th, when expert opinion held that Hillary Clinton was almost sure to win, 1) the value of the U.S. stock market has increased by just over $2 trillion, according to Bloomberg, 2) the expected real growth rate of the U.S. economy has increased by roughly 0.5% per year according to the bond market, which translates into an additional $1 trillion per year in national income, and 3) the global purchasing power of U.S. residents has increased by about 6% according to the foreign exchange markets. You might call those gains Trump-Trillions.

The chart above shows the value of the U.S. stock market (in trillions of dollars).

The chart above shows the real yield on 5-yr TIPS, which is a good proxy for the market's economic growth expectations. About two-thirds of the 80 bps increase in 5-yr Treasury yields since the election has been due to an increase in real yields.

The chart above shows the trade-weighted value of the dollar vis a vis other major currencies, which is up about 6% since the election.

In a sign that the world's general level of discomfort has eased measurably, gold is down over 13% since the election.

The question now becomes whether the market has gotten ahead of itself. According to Mohamed El-Erian, the market has "priced in no policy mistakes ... no market accidents ... [and] ignored all sorts of political issues." I'm not sure I'd put it the same way, but it's undoubtedly the case that the market has priced in good things that have not yet happened, and that leaves the market vulnerable to disappointments. Further gains over the six months or so will probably require concrete achievements, not to mention a pickup in corporate profits and an actual reduction in tax and regulatory burdens.

Over the long haul, I think there's still lots of upside potential. To support that assertion, I offer the following chart, which suggests that the real yield on 5-yr TIPS would have to increase significantly if the market were to price in a booming economy with 4-5% real growth rates.

Tuesday, December 20, 2016

Here's another update of an indicator I've been highlighting for the past several months. The American Chemistry Council's Chemical Activity Barometer (see chart above) hit a new all-time high this month, rounding out a significant pickup in the second half of this year, and suggesting that the economy will register stronger growth in the months to come.

As the chart above shows, the year over year gain in the 3-mo. moving average of the CAB has tended to lead a similar gain in industrial production, which has been weak for some time now.

HT: Calculated Risk, which has been covering this issue in greater detail for some time now.

Wednesday, December 14, 2016

The Fed increased its target short-term interest rate today to 0.75%, but that doesn't represent a tightening of monetary policy. It would be more correct to say that today monetary policy became slightly less accommodative. Neither the market nor the economy has anything to fear from today's Fed action. Financial markets today enjoy plentiful liquidity conditions, and confidence in general in rising. Interest rates have adjusted upwards slightly to reflect this. Remember: higher interest rates don't threaten growth; interest rates are higher because growth expectations are somewhat stronger. This is all good news. Today's modest decline in equity prices is more a buying opportunity than a warning sign.

The chart above compares the current real short-term rate (red) with the market's expectation for what the average real short-term rate will be over the next 5 years (blue). The current real short-term rate is about -1%, and that rate is expected to average about zero over the next 5 years. There is no way this represents a tightening of monetary policy for the foreseeable future. And since the real yield curve is still positively sloped (i.e., the blue line is higher than the red line), that is yet another indication that monetary policy is not tight, nor is it even beginning to get tight. The time to worry is when the red line approaches and exceeds the blue line (as happened prior to the past two recessions), because that is the market's way of saying the Fed is tight enough to threaten growth.

The chart above shows that the prices of gold and 5-yr TIPS continue to track each other (using the inverse of the real yield on TIPS as a proxy for their price). This is significant, because it says that the market is willing to pay less for the protection of TIPS and gold, and that in turn is equivalent to saying that the market is regaining confidence in the future. Gold is still quite expensive (my calculations say that the long-term average price of gold in today's dollars is somewhere in the neighborhood of $500-600 per ounce), and real yields are still very low, so it's still the case that the market is on the defensive, and risk aversion is still evident.

Swap spreads are almost exactly at a level which is "normal." That means that liquidity conditions are very healthy, and it further suggests that the outlook for growth is also healthy. No one is being starved of liquidity as a result of the Fed's "tightening" of monetary policy. In the past, prior to IOER, the Fed tightened by reducing the availability of bank reserves, which tends to shrink the amount of money in the financial system. But that is not the case today. All the Fed has done is to change the appeal of holding cash equivalents—by making them somewhat more attractive on the margin. That is a prudent move, because the recent rise in the equity market tells us that the market is becoming more optimistic on the margin about the future, and more optimism would imply less demand for cash equivalents. The Fed needs to respond to rising optimism by making bank reserves more attractive; otherwise banks might be tempted to lend too much, and that could give us higher-than-expected inflation.

As the chart above shows, credit spreads are still relatively low. That's another way of saying that the Fed's move today presents no threat to economic growth. Markets are comfortable with the Fed's move, and generally agree with the Fed's assessment that the economic outlook has improved somewhat and that higher real rates are justified.

Monday, December 12, 2016

Over the weekend we had dinner with friends in north San Diego County. His firm provides consulting services to other firms that are in the initial stages of planning residential and commercial projects in the area—projects that won't be finished for 2-3 years. "Last summer was the worst summer we have ever had," he lamented. New business all but dried up. But days after the November election new business began pouring in. He's busier now than ever before.

This squares with what I have been thinking for the last six months or so: faced with the extreme uncertainties surrounding the election, decision makers would be compelled to put new projects on hold, thus weakening the economy. But now that Trump has won and it appears likely that he is going to advocate for reduced tax and regulatory burdens, decision makers are much more willing to pull the trigger on major project decisions. If "animal spirits" are perking up even before tax and regulatory burdens have been cut, imagine what might happen if and when they actually are.

This is only anecdotal evidence, to be sure. But I'm pretty sure that next year promises to be a much better one for the economy.

UPDATE (11/13/16): The NFID Small Business Optimism Index jumped almost 4% in November, thus providing some corroboration for what I learned from my friend.

Sunday, December 11, 2016

Last Friday the Fed released its Q3/16 estimate of the balance sheets of U.S. households. Collectively, our net worth reached a new high in nominal, real, and per capita terms. We are living in the weakest recovery ever, and things could and should be a lot better, but it is still the case that today we are better off than ever before.

As of September 30, 2016, the net worth of U.S. households (including that of Non-Profit Organizations, which exist for the benefit of all) reached a staggering $90.2 trillion. To put that in perspective, it's about one third more than the value of all global equity markets, which were worth $66 trillion at the end of September, according to Bloomberg. I note that household liabilities have increased by only $300 billion since their 2008 peak; the value of real estate holdings is up about 5% from that of the "bubble" high of 2006 (10 years ago!); and financial asset holdings have soared since pre-crash levels, thanks to significant gains in savings deposits, bonds, and equities.

In real terms, household net worth has grown at a 3.6% annualized rate for the past 65 years.

On a real per capita basis (i.e., after adjusting for inflation and population growth), the net worth of the average person living in the U.S. has reached a new all-time high of $278K, up from $62K in 1950. This measure of wealth has been rising, on average, about 2.4% per year since records were first kept beginning in 1951. By this metric, life in the U.S. has been getting better and better for generations.

The ongoing accumulation of wealth is not a house of cards built on a bulging debt bubble either, regardless of what you might hear from the scaremongers. As the chart above shows, the typical household has cut its leverage by over 30% (from 22% to 15%) since early 2009. Households have been prudently and impressively strengthening their balance sheets over the past seven years by saving and investing more and by sharply reducing the use of debt financing.

Friday, December 9, 2016

The Chinese yuan has fallen from a high 6 per dollar three years ago to 6.91 today, and China's foreign exchange reserves have fallen from a high of $3.99 trillion in mid-2014 to $$3.05 trillion as of the end of November. Yet despite the almost 25% decline in China's forex reserves (a key component of China's monetary base), the amount of money in China continues to grow, and has increased over 10% in the past year. There is something wrong with this picture.

A declining yuan alongside declining forex reserves is powerful evidence of significant capital flight. Investors, individuals, and corporations apparently wish to reduce their exposure to the Chinese economy, and that's why the demand for yuan is falling. This problem won't be solved until the dollar value of the Chinese money supply declines by enough to match the decline in the demand for yuan. That can be accomplished by 1) shrinking the monetary base and the money supply, 2) devaluing the yuan vis a vis the dollar, and/or 3) inflating the Chinese price level. Alternatively, China could take steps to boost confidence in the yuan (e.g., by allowing the monetary base to shrink) or boost the demand for yuan (e.g., anything that improves China's long-term economic growth potential).

China's forex reserves are declining because the central bank is selling its foreign assets (mostly held in dollar securities), in an effort to try to support the currency; in effect the central bank is accommodating capital flight. The fact that the currency continues to decline suggests that forex sales have not been sufficient to stem the decline. It's not too hard to see why: the central bank is not allowing the decline in reserves to shrink the monetary base, and indeed, the amount of yuan in circulation continues to rise. Ordinarily, capital flight that is accommodated by central bank sales of forex would result in a shrinkage in the money supply, and that shrinkage would eventually bring the supply of yuan back into line with the declining demand for yuan.

To make matters worse, the ongoing increase in the amount of yuan in China, despite the decline in the demand for same, means the central bank is selling dollar assets and buying Chinese assets, thus “degrading” the quality of the yuan and allowing the oversupply of yuan to continue. The central bank is not allowing capital flight to shrink the monetary base. Replacing dollar assets with yuan-denominated assets in the monetary base is eroding the effective quality of the yuan, and that does little or nothing to maintain confidence in the yuan.

China is not taking adequate steps to address the decline in the demand for yuan. This means that the problem of capital flight and the decline in the value of the yuan will continue, despite China's best efforts to physically stem capital flight. It also means that Chinese inflation is likely to rise. Unless properly addressed, these problems will persist, and they will further weaken the Chinese economy. That is not good for China or for the world. It's difficult to see how exactly this will play out, and what impact it could have on the U.S. economy.

A crisis is not likely imminent, however, since China still sits on a virtual mountain of forex reserves, and the dollar value of Shanghai Composite Index is up over 15% since January. But as John Cochrane muses, and today's WSJ op-ed points out, there are disturbing things going on that bear watching.

At the very least, this makes Trump's demand that China boost the value of its currency vis a vis the dollar a virtual impossibility.

The chart above summarizes the central facts. As it suggests, the persistence of capital flight is forcing the central bank to devalue the yuan.

Despite the yuan's decline in recent years, it is still very strong against a basket of trade-weighted, inflation-adjusted currencies.

Wednesday, December 7, 2016

Here's an update of one of my favorite charts. I show it in honor of another decisive market move to new all-time highs that has been accompanied, not surprisingly, by a significant decline in the market's level of fear and a meaningful rise in interest rates, which in turn reflects a more confident growth outlook.

Tuesday, December 6, 2016

10-yr Treasury yields have jumped 100 bps in the past 5 months, 30-yr fixed-rate mortgages are up almost 70 bps since August (to 4.0%), and the bond market is convinced that the Fed will raise short-term interest rates to 0.75% at its meeting next week. A good part of the rise in 10-yr yields since their all-time low back in early July was due to an improvement in the economy's fundamentals (GDP growth in the third quarter was 3.2%, up from 1.4% in the second quarter), whereas a little over half of the rise in yields has occurred since Trump's surprise election victory. A further breakdown of the rise in yields reveals that about half was due to stronger growth expectations (real TIPS yields are up about 50 bps), and half was due to higher inflation expectations (which are now up to 1.9-2.0% for the next 5 and 10 years).

So it would appear that interest rates are well on their way to normalizing, right? Well, not exactly. According to the implied pricing of the Treasury curve, the bond market is expecting only a gradual rise in note and bond yields over the next several years—less, in fact, than what has occurred in the past 5 months. Whether this is reasonable or not is the issue confronting investors today. If rates end up rising by more or by less than the market currently anticipates, that could have a big impact on interest-sensitive sectors such as utilities and real estate, both of which have already been hit by the recent and unexpected rise in rates.

The chart above compares the current level of the Treasury yield curve (blue line), with the bond market's implied forward yields (i.e., the future yield which is implied by current yields) over the next 2 and 3 years. Most of the eventual rise of yields is expected to occur over the next year, with the Fed expected to raise short term rates another two or maybe three times (to at most 1.5%) over the next 12 months. Beyond that, the market sees the Fed's target rate rising to at most 2% by the end of 2019, and possibly 2.25% by the end of 2020. 5-yr Treasury yields are expected to rise from 1.84% currently to 2.6% by the end of next year, and 2.8% by the end of 2019. 10-yr yields are expected to rise from 2.4% currently to 2.7% by the end of next year, and 3.1% by the end of 2019. The market expects that it will take at least 7 years for 10-yr yields to rise by 100 bps from where they stand currently.

Now let's put these rates in context. As the chart above shows, 5-yr Treasury yields not too long ago were as high as 5%, at a time when core CPI inflation was funning at 2.5-3% and real GDP growth was 2.5-3%. If that was "normal," then today's 1.8% 5-yr yields should be almost 200 bps higher, given the current level of core CPI inflation.

The current level of real and nominal 5-yr Treasury yields (see chart above) tell us that the market is expecting CPI inflation to average about 1.9% per year over the next 5 years. It's unusual, to say the least, for nominal 5-yr yields (currently 1.8%) to be less than the expected future inflation rate over the next 5 years. "Normally," nominal 5-yr yields are 1 or 2 percentage points above expected inflation. Inflation expectations seem reasonable (the core CPI has increased almost 2% per year over the past 10 years), but the level of nominal and real yields seems unusually low, despite their recent jump. This suggests that the market is still priced to miserably low growth expectations. Which further suggests that if Trump's economic plan ends up providing the economy with a significant boost, it's fair to say the market will be quite surprised, and yields will move significantly higher.

The charts above show how the recent move up in 10-yr Treasury yields has affected 30-yr fixed mortgage rates, which are up about 70 bps from their recent, all-time lows. Mortgage rates are still very low from an historical perspective. They were much higher when the housing market was booming in the early 2000s.

Even with the recent jumps in interest rates, and the Fed's almost certain hike in short-term rates next week, it appears that interest rates are still very low and not expected to rise much more in coming years. If you believe there is a decent chance that Trump's economic policies could get the economy back on a healthier growth track, then you need to be very worried about further unexpected rises in interest rates.

While higher-than-expected increases in 5- and 10-yr Treasury yields would definitely be bad news for bond investors, they would not necessarily be bad news for interest-sensitive sectors of the economy. That's primarily due to the fact that higher-than-expected interest rates would most likely come hand in hand with stronger-than expected growth and possibly higher-than-expected inflation. The negative impact of higher than expected rates on the real estate market, however, could be substantially mitigated by the positive effects of stronger growth and higher inflation. It's not obvious, in other words, whether real estate investors should be worried about higher interest rates. Ditto for the utility sector, where prices have already discounted further hikes in interest rates, but not a further strengthening of the economy.

The key thing to keep in mind is this: if interest rates rise by more than expected, it will almost surely be because growth and/or inflation prove to be stronger than expected. Higher interest rates aren't a threat to growth, because stronger growth will boost interest rates.

Thursday, December 1, 2016

Both inflation and real growth are getting a modest lift these days. Recent economic data continue to support the notion that economic activity has firmed a bit in the second half of the year, after being weak in the first half. The improvement is modest, but nevertheless encouraging, especially since there are signs that overseas activity is picking up as well. The market is also pricing in a modest pickup in inflation, with expectations now centering around 2% over the next 5 and 10 years.

As the chart above suggests, he November ISM manufacturing report is consistent with an economy that is growing at a modest 2-3% pace.

It's encouraging that Eurozone manufacturing surveys point to some improvement in the second half there as well.

Industrial metals prices have surged almost 45% year to date, and that is very impressive. Some of the upward impetus could be speculative in nature, a bet that a Trump administration ramp up infrastructure spending in a big way. The hoopla surrounding the ARRA infrastructure spending bonanza was way overblown, but this time could be different. Instead of relying on local governments to identify "shovel-ready" projects, Trump may instead rely more on tax incentives and private sector funding, and that could mean an infrastructure push that could be more efficient and more productive. Caterpillar stock, up 60% since January, is sending the same message. However, I note that prices have been increasing all year, well in advance of any expectation that Trump might win.

This year has seen a remarkable divergence between the value of the dollar and industrial commodity prices. They normally move inversely (e.g., a stronger dollar coinciding with weaker commodity prices), but this year both the dollar and commodity prices have moved up (resulting in the divergence shown in the chart above). When prices move inversely it is a sign that the change in commodity prices has a monetary component (e.g., tight money is pushing the dollar up and deflating commodity prices). Now that they are moving together it could be that the rise in commodity prices is mostly being driven by improving economic fundamentals both here and abroad: prices are rising because demand is outstripping supply. The dollar has its own reasons for rising: the Fed is clearly in a mood to raise rates, while most other central banks are still on the sidelines. More recently, the dollar has gotten a boost from speculation that a Trump administration will be more growth-friendly.

Traditionally, a stronger dollar has spelled bad news for emerging market economies. That's because a stronger dollar has usually coincided with weaker commodity prices, and commodities are very important to emerging market economies. But this time emerging market economies have been taking a beating of late, even though commodity prices have been rising. Perhaps there is too much pessimism? Might it be the case that a stronger dollar and an improving U.S. economy and rising commodities will act like a rising tide that lifts all economies, particular those in the Western hemisphere?

The yen has fallen almost 13% against the dollar in just the past 3 months, and Japanese stocks have reversed to the upside. The strong inverse correlation between the value of the yen and the stock market is still in place. It's unusual for a weaker currency to be good for a country's stocks, but the case of Japan looks different from that of most countries. A weaker yen may be a sign that deflationary pressures—which have weighed heavily and uniquely on Japan's economy for many years—are being replaced by some much-needed reflation.

The U.S. stock market has outperformed the Eurozone stock market for many years now, and nothing seems to have changed of late. The outlook for the U.S. economy is still brighter than it is for the Eurozone economy.

Inflation expectations, as derived from the prices of TIPS and Treasuries, have moved meaningfully higher in the past three months. The chart above shows how this has played out with 5-yr TIPS and 5-yr Treasuries. Nominal yields have risen much more than real yields, with the breakeven spread (equivalent to the expected average annual rise in the CPI over the next 5 years) rising from a low of 1.3% in early August to now 1.9%. 10-yr inflation expectations are now 2.0%. At the very least this means that deflation worries are a thing of the past.

Caution: if this process continues (i.e., if inflation expectations continue to rise), it will mean that the Fed is falling behind the inflation curve and will therefore need to speed up its normalization of short-term interest rates. As I've warned for years, the Fed's biggest nightmare is the return of confidence, and confidence is definitely picking up these days. With rising confidence and less risk aversion, the pubic's demand for all the money that has been created in the past 8 years will begin to decline, unless the Fed takes offsetting measures to boost money demand by raising short-term interest rates.

UPDATE: As seen in the chart below, the Chemical Activity Barometer is still rising impressively, up 4% in the year ending November. Such a move has tended to foreshadow a pickup in industrial production, which has been flat for quite awhile.

Wednesday, November 30, 2016

The collapse of oil prices that began over two years took a big bite out of corporate profits, but now that oil prices have been relatively stable for the past year or so, corporate profits are rebounding. Profits are still below their previous highs, both nominally and relative to GDP, but they are still healthy from an historical perspective. Using the measure of corporate profits that comes from the National Income and Product Accounts as the E, and the S&P 500 index as the P, PE ratios are only modestly above their long-term average.

The chart above shows after-tax corporate profits (for all corporations), adjusted for capital consumption allowances and inventory valuation. This is considered to be the best measure of "economic" profits over time, as distinct from FASB profits. Note that profits are up over 13% in the past nine months, and were only briefly higher in the period just before oil prices collapsed. Note also that profits have tripled in the past 16 years, over which period the S&P 500 rose only about 50%.

The chart above compares this same measure of profits to nominal GDP. For the past 70 years or so, profits have averaged just over 6% of GDP. Today they stand at 8.5%. (The y-axes of the above graph are set so that the red and blue lines intersect when profits are equal to 5% of GDP.) For years, stock market skeptics have argued that profits were mean-reverting, and would inevitably fall from the 8-9% levels relative to GDP that were achieved in late 2009 and early 2010. That has not happened. I've theorized for years that profits can sustain a level relative to GDP that is higher than what we saw prior to the late 1990s because of globalization: U.S. firms are now able to address a market that is significantly and permanently larger than it was prior to the mid-1990s. As an example, consider that since the mid-1990s, U.S. international trade has roughly doubled in size relative to GDP, from 6-7% to almost 15%.

If NIPA profits are superior to FASB profits, as Art Laffer has argued for decades, then it makes sense to use NIPA profits to calculate PE ratios. The chart above does just that, using NIPA profits as the E, and the S&P 500 index as the P. (The S&P 500 index is arguably a reliable proxy for the valuation of all U.S. corporations.) I've normalized the numbers so that the long-term average of this series is equal to the long-term average of PE ratios as calculated by Bloomberg, using adjusted FASB profits. Here we see that PE ratios are only slightly above average (17.5 vs. 16.5).

At the very least, these charts support the notion that stocks are not egregiously overvalued, as many continue to argue.

Tuesday, November 29, 2016

Third quarter GDP growth was revised upwards slightly today, from 3.0% to 3.2%. This is encouraging, of course, but it does little to change the bigger picture, which is one of unusually slow growth. Over the past year, the economy has expanded by a very modest 1.6%, and over the past two years it has risen at a mere 1.9% annualized rate. It's managed annualized growth of only 2.1% since the recovery began in mid-2009. I can think of no better way to emphasize how painful this recovery has been than the following chart, which I have been featuring and updating regularly for many years now:

The chart above uses a semi-log scale on the y-axis to emphasize how, for 40 years, the economy has followed a 3.1% annualized real growth path, bouncing back after every recession except for the last one. Never before has the U.S. economy posted such a weak recovery and such a long period of sub-par growth. Demographics—the retirement of baby boomers—can explain some of the slow growth since late 2008, but not all of it; demographic changes take years to unfold.

What we do know is that business investment has been very weak, especially in recent years, and despite record-setting profits; jobs growth has been modest; and productivity has been miserable. At root, I believe the underlying problem has been a lack of "animal spirits," a shortfall of confidence, and the persistence of risk aversion. People have simply been unwilling to work and invest more. We also know that, beginning in 2009, the economy has been burdened by 1) an unprecedented remaking of the entire healthcare industry (Obamacare) which in turn has impacted the lives and healthcare costs of nearly everyone, 2) sweeping new regulatory burdens on the financial industry (e.g., Dodd-Frank), 3) a massive increase in government spending and transfer payments (the ARRA), 4) higher marginal tax rates on income, dividends, and capital gains, and 5) a huge increase in the federal debt burden. You don't have to have a political bias to believe that these changes could go a long way to explaining why the economy has been so weak during the Obama years.

Let's call this the Obama Gap. It's depressing because it represents a huge amount of lost income and jobs that were never created. But to look on the bright side, it is a measure of the massive amount of untapped potential in the U.S. economy. If my analysis of the economy's current malaise is correct, then if the Trump administration can succeed in rolling back the burdens heaped upon the economy in the past 8 years, the future growth potential of the U.S. economy could be enormous. For example, it would take 5% real growth per year over the next 8 years just to close the Obama Gap.

Here are some recent and encouraging developments that suggest the market is in the very early stages of anticipating the unlocking of the economy's upside potential:

I've been following this chart for a number of years, and the relatively tight relationship between the price of 5-yr TIPS and gold never ceases to amaze me. (I use the inverse of the real yield on 5-yr TIPS as a proxy for their price.) Two completely different asset classes have behaved in a similar fashion for the past 10 years! The one thing that gold and TIPS have in common is that they are both a refuge from uncertainty: gold is the classic "port in a storm," and TIPS are not only government-guaranteed but also promise protection from inflation. Both have declined in price in recent weeks, and I think that is a sign that the market is less desirous of paying for protection, and by inference, somewhat less risk averse.

The Conference Board today released their November estimate for consumer confidence, and it registered a new high for the current business cycle. Confidence is still lower than it has been during previous recoveries, but it is moving a positive direction.

Since November 4th, the Vix index has fallen from 22.5 to 12.7, and the 10-yr Treasury yield has jumped from 1.8% to 2.3%. That adds up to less uncertainty and more confidence in the economy's ability to grow. Not surprisingly, the stock market is up almost 6% over the same period.

The chart above shows that there is a decent correlation between the economy's underlying growth rate and the level of real yields on 5-yr TIPS. Real yields are up some 40 bps since November 4th, which suggests the market is pricing in a modest increase in the economy's underlying growth potential. This might be just the beginning of a significant rise in real yields, however: the chart suggests that if the economy manages to sustain 4-5% annual rates of growth, real yields could rise to 3% or more. That would further imply 5% nominal yields, assuming inflation expectations don't change much from where they are currently. If we manage to close a decent portion of the Obama Gap, then the Fed is still in the very early stages of hiking short-term rates.

Would a huge increase in nominal and real yields kill the economy? No, because yields don't cause growth; yields are driven by inflation, growth, and expectations for the future. Higher yields would be the natural consequence of stronger growth, not the enemy of growth.

Monetary policy only becomes a threat to growth when the real and nominal yield curves become flat or inverted. Flat or inverted yield curves are a sign that the market realizes that the Fed is more likely to cut rates in the future than raise them, and that in turn only happens when high real and nominal rates begin to depress economic activity. The chart above shows the current real short-term rate (red line) and the market's expectation of where real short-term rates will be in five years (blue line); it's positive, and that means the real yield curve is still upward-sloping. I wouldn't start to worry about the Fed unless and until the red line moves above the blue line—which is what happened prior to the last two recessions. We're likely still years away from that point.

Wednesday, November 23, 2016

To paraphrase Peter Thiel, Trump's supporters take him seriously, but not literally, while Trump detractors take him literally, but not seriously. There's a lot of truth in that observation, because the more we know about Trump the more we realize that his bark is worse than his bite. He's not an inflexible ideologue; he's a businessman who wants to win. Maybe, just maybe, Trump is NOT going to start a trade war with tariffs (sticks); what if he wants instead to use carrots to boost trade and thus the economy?

Trump's interview with the New York Times yesterday is quite revealing in this regard, and very encouraging. Here's the money quote from Trump:

I got a call from Tim Cook at Apple, and I said, ‘Tim, you know one of the things that will be a real achievement for me is when I get Apple to build a big plant in the United States, or many big plants in the United States, where instead of going to China, and going to Vietnam, and going to the places that you go to, you’re making your product right here.’ He said, ‘I understand that.’ I said: ‘I think we’ll create the incentives for you, and I think you’re going to do it. We’re going for a very large tax cut for corporations, which you’ll be happy about.’ But we’re going for big tax cuts, we have to get rid of regulations, regulations are making it impossible. Whether you’re liberal or conservative, I mean I could sit down and show you regulations that anybody would agree are ridiculous. It’s gotten to be a free-for-all. And companies can’t, they can’t even start up, they can’t expand, they’re choking.

This is extremely encouraging. Obama's approach to keeping jobs in the U.S. was to penalize corporations for doing inversions. Trump's approach is to create incentives—lower taxes and reduced regulatory burdens—for corporations to relocate here, to bring jobs back. Obama preferred the stick approach, while Trump appears to favor the carrot approach. Guess which one works better? It's like with capital controls: if a country won't allow capital to leave, it will never come in the first place. The best way to attract capital is to assure the owners of capital that they can take their money out whenever they want, with no penalty, and with no losses from devaluations and/or inflation in the meantime.

Trump is a businessman, and he understands how businesses work. He understands that incentives are important. Obama never understood this, and that's one big reason why the economy has been so weak for the past 8 years. I'm starting to get very optimistic about the future.

Monday, November 21, 2016

The stock market is making new all-time highs, even as the bond market is getting crushed; 10-yr Treasury yields are up almost 100 bps since their all-time low in early July. Industrial commodity prices are on a tear, yet the U.S. dollar is gaining against almost all currencies. These seeming contradictions (Aren't higher rates supposed to be bad for the economy? Don't commodity prices usually move inversely with the dollar?) aren't a portent of doom, they're more likely symptomatic of an improving global economic outlook, led by the U.S. economy.

President-elect Trump appears to be a catalyst for the recent surge in stock prices and the dollar, since the market is right to be encouraged by the prospect of lower tax rates and less burdensome regulations if Trump gets his way (ignoring for the moment his terribly misguided trade bombast). But Trump doesn't get all the credit: the healthy trends underway today began way before Trump was even close to becoming president. As I pointed out some four years ago, and which is now clearer than ever, the Obama years have had one very positive result from the perspective of economists. They have been the equivalent of a laboratory experiment designed to answer the question "Can government spending stimulate the economy?" For decades economists have debated the value of the government spending multiplier (i.e., how many extra dollars of GDP does one dollar of additional government spending create?). Keynesians have generally argued that the multiplier was greater than one, while supply-siders have generally argued it was less than one. We now know for sure that it is less than one, and it could very possibly be negative. More government spending most probably means less economic growth.

As I argued back then, the ARRA was a disaster:

American taxpayers borrowed $840 billion only to learn that the payoff was a small fraction of the additional debt incurred. We wasted almost a trillion dollars of the economy's scarce resources, and that's a big reason why the recovery has been so disappointing. If we had instead "spent" the money on lowering tax rates for everyone (e.g., we could have eliminated corporate taxes for three years with the ARRA money spent) in order to give them a greater incentive to work and invest, the results could have been dramatically better. The tax cuts might even have paid for themselves in the form of a stronger recovery over time.

And its effects have lingered, giving us the weakest recovery on record. As I noted over two years ago, federal deficits effectively absorbed all the profits of U.S. corporations since the latter half of 2008:

Despite assurances from politicians and most economists of Keynesian persuasion, not only did the biggest and most rapid increase in our federal debt burden since WW II fail to boost the economy, it coincided with the weakest recovery in history—growth of only 2.2% per year on average. (I was among those who warned in late 2008 that this would happen, and quite a few times over the years following.) This is not a problem of not spending enough, it is a failure of ideology, and arguably the most expensive such failure in the history of the world.

In short, most of what U.S. businesses have managed to produce in the way of profits in the current business cycle expansion have been borrowed by the federal government only to be flushed down the Keynesian toilet. Starved of basic investment nutrients, the economy has been weak and the public is frustrated. A weak economy—which today is some $3 trillion smaller than it might have been with better policies—is the measure of our discontent. Weak growth is the root cause of people's frustration with trade, and the reason the recent election was all about spurning the ruling elite, who think that they can pull the policy strings and magically create growth and prosperity. Most people figure they could be working more productively, and they'd rather have a better job than more government handouts. Among other things, Hillary Clinton made the mistake of promising free college and a higher minimum wage to a public that instinctively understood that there is no free lunch.

The other really big thing that has affected the economy for years, and yet is generally misunderstood, is monetary policy, and more specifically Quantitative Easing. Most people think that QE was all about artificially lowering interest rates in order to stimulate the economy. But how is it that the Fed has purchased more than $3 trillion worth of notes and bonds since 2008, yet there has been no appreciable impact on growth or inflation?

The Fed is complicit in the public's misunderstanding, since it has falsely represented QE as "stimulus." In fact it was not stimulus at all: it was accommodation. The 2008 financial collapse struck such fear into the heart of the markets and investors that risk aversion and strong demand for money and other safe assets has been the predominant driver of market sentiment ever since. Last year I recapped this argument, noting that "QE was not about pumping money into the economy, it was all about satisfying the economy's demand for liquidity. QE was erroneously billed as "stimulative," since printing money in excess of what's needed only stimulates inflation. Instead, QE was designed to accommodate intense demand for money, without which the economy might well have stumbled." The proof is in the pudding: despite years of an unprecedented expansion of the monetary base, inflation remains relatively low. If the Fed had truly been "printing money" we would have seen much higher inflation by now. The Fed supplied the money the market needed, and interest rates fell because the economy could not manage to deliver anything resembling normal growth.

Going forward, this means that we must watch very carefully whether and by how much the public is regaining confidence and becoming less risk averse. As I've said quite a few times in recent years, the return of confidence is the Fed's worst nightmare. More confidence and less risk aversion would almost surely go hand in hand with reduced demand for money and safe assets in general. If the Fed doesn't take timely steps to offset a reduction in the demand for money (by reducing the supply of excess reserves and increasing the interest it pays on excess reserves), then inflation could come back with a vengeance.

So now we know that 1) government "stimulus" spending doesn't stimulate, especially when accompanied by rising tax and regulatory burdens, and 2) monetary "stimulus" didn't
stimulate growth, since all it did was accommodate a risk averse public with an enormous appetite for safe assets. This understanding will help us track whether President Trump is making things better and whether the Fed is going to keep the dollar strong and inflation low.

Trade policy will be very important as well, since free trade is undeniably good. Yet, thanks to Trump, free trade unfortunately has gotten a bad rap in recent years since it has been blamed for the loss of millions of jobs. Fortunately, David Malpass is a key figure in Trump's economic policy team, and I've known him for many years. He's a solid supply-sider, with plenty of public policy experience and a deep appreciation for markets. He fully understands the importance of free trade. Yesterday the WSJ excerpted some of his recent remarks on economic policy issues. On the subject of Nafta (North American Free Trade Agreement), David makes it clear that the problem with Nafta is not that it has made trade free, but that it has made trade less free:

I was there at the beginning of Nafta. The idea of Nafta was, it was supposed to be…a very clear, free-market orientation that would allow both sides of the border to do what they do best in the classical sense of more commerce.

But as it was negotiated, year after year, special interests descended upon it. And it got thicker and thicker and thicker. This was 1989, 1990 and into 1991. It’s up to 1,200 pages and then [President George H.W.] Bush left, [President Bill] Clinton came in and added the environmental chapter and the labor chapter.

It became this monstrously large, managed trade process that doesn’t work at all for small businesses in the U.S…. There are too many parts of it that are not working.

In other words, he wants to make "free trade" freer, not less free. This is very encouraging. If lower and flatter taxes and less regulation can boost the economy (and I'm sure they can), I'm confident that with David's help, Trump can renegotiate existing trade agreements in order to make them more free, and that in turn will help boost the economy. A stronger economy will then help absorb the millions of workers who lose their jobs to overseas competitors. To sum up: the problems associated with free trade today stem from the fact that 1) trade hasn't been as free as it should have been, and 2) the economy has been too weak to create new jobs to replace the ones lost to more efficient overseas markets.

If Trump ignores Malpass, preferring to slap punitive tariffs on China rather than negotiate better and freer trade agreements, then this won't help at all. We'll have to keep a close watch on this.

What follows are updated charts which illustrate these themes and how they are progressing.

The chart above illustrates how fear, uncertainty and doubt about the economy's strength have sparked every one of the market's downturns in recent years. The recent decline in the red line has been driven by a decline in the Vix index (the fear index) and a sharp rise in 10-yr Treasury yields (one measure of the market's confidence in the future strength of the economy). As each of these panic attacks have faded, the market has gone on to higher levels.

The CRB Metals index is up 40% over the past year, and it is up "yuge" regardless of which currency it is measured against. This strongly suggests that global economic activity is picking up.

I doubt many people are aware of this fact: excess bank reserves have fallen over 25% from their high of a few years ago. The Fed has been conducting a stealthy and sizable reduction in the amount of reserves that banks could use to exponentially increase their lending—and the money supply—if they so chose. This is an under-appreciated good development.

The current PE ratio of the S&P 500 is 20.5, according to Bloomberg, which means that the earnings yield on stocks (the inverse of the PE ratio) has fallen to just under 5%. PE ratios are meaningfully above their long-term average of 16, but the earnings yield on stocks is still significantly higher than the yield on 10-yr Treasuries (see chart above). When stocks are priced so that they yield a lot more than risk-free Treasuries, it's a good bet that the market deeply distrusts the ability of corporate earnings to sustain their current levels. (Since stocks generally have expected returns that are higher than risk-free returns, a "normal" state of affairs would have earnings yields equal to or lower than risk-free yields.) In other words, the fact that the equity risk premium is still quite positive is a good sign that risk aversion is still the order of the day in the equity market, although risk aversion does appear to be declining on the margin.

Not surprisingly, consumer confidence is only modestly above its long-term average, as the chart above illustrates. Confidence has been improving on the margin, but it is still far from what we might term exuberant.

The chart above compares the prices of gold and 5-yr TIPS (using the inverse of their real yield as a proxy for their price), both of which are considered to be "safe" assets. Gold is a classic refuge from all sorts of uncertainties, and TIPS are not only risk-free but also protected against inflation. Both have been declining on the margin, and that is a good indicator that confidence is rising and risk aversion is declining. But prices are still quite elevated from an historical perspective.

The chart above suggests that the current level of real yields on 5-yr TIPS is consistent with an expectation that real economic growth is going to be somewhere in the neighborhood of 2 - 2 ½% going forward. That's better that the growth we've seen over the past year, but still a far cry from the robust growth we enjoyed in the late 1990s. If 5-yr TIPS yields get back up to 2% I'm going to be very excited about the prospects for the U.S. economy.

The two charts above illustrate the dramatic increase in money demand over the past two decades. The amount of "money" (as defined here by M2, which is the sum of currency in circulation, time deposits, checking accounts, retail money market funds, and bank savings deposits) relative to national income has never been so high. Relative to long-term trends, there is arguably as much as $2 trillion of "extra" money in the economy today, which is another sign that risk aversion is still a big deal. Most if not all of the increase in M2 has come from an increase in bank savings deposits, which still pay almost nothing. People are holding almost $9 trillion in bank deposits these days, preferring their safety to the much higher yields available on riskier assets.

Over the past 8 years M2 has been increasing at an annualized rate of 7-8%, while nominal GDP has been increasing at about a 4% annualized rate. Relative to the size of the economy, the amount of money being held by the public has increased by over 50%. If the public should ever want to reduce its holdings of so much money, what might happen? Bear in mind that wanting to hold less money doesn't mean that money just disappears. I can reduce my holdings of money, but only if someone else increases theirs. Should the public on balance want to hold less money relative to incomes, the only way that can be accomplished is by increasing the nominal size of the economy. In short, wages and prices would have to rise if the public wants to reduce its money balances.

There's a lot of money out there that could wind up bidding up the prices of goods and services if the public were to fully regain its confidence in the future. That's a lot of inflation potential to worry about, but it only becomes a concern if confidence rises and the Fed fails to take offsetting measures (e.g., raising short-term interest rates by enough to keep the demand for bank deposits from declining). Call it the Trump Paradox, in which good news could turn out to be bad news if the Fed flubs its job.